Fixed exchange rate with higher domestic inflation erodes competitiveness

Steps:

• Higher domestic inflation raises prices of goods and services relative to trading partners.
• Fixed exchange rate keeps nominal currency value unchanged, causing real exchange rate appreciation.
• This makes domestic exports more expensive for foreigners, reducing export volume.
• Foreign imports become cheaper domestically, increasing import volume.

Why C is correct:

• Real appreciation from differential inflation reduces export competitiveness (lower volume) while boosting import demand (higher volume), per balance of payments theory.

Why the others are wrong:

• A: Both cannot decrease; imports rise due to cheaper foreign goods.
• B: Exports do not increase; they fall from lost competitiveness.
• D: Imports do not decrease; they rise from relative price advantage.

Final answer: C